A Tepid Reception for Annuities as 401(k) Payouts

In late October, most of the attention surrounding 401(k) policy centered on Department of Labor regulations regarding qualified default investments.

Another change is imminent, but its profile is not quite as high. In early September, the agency issued an interim final rule on the use of annuities as a disbursement mechanism for defined-contribution retirement plans.

The new regulation is required by the Pension Protection Act, the landmark federal law passed last year. Essentially, the regulation loosens the fiduciary requirement that a plan sponsor choose the "safest available" annuity—a product that provides a guaranteed payout over the lifetime of the recipient.

Under the new safe harbor rule, an employer must "conduct an objective, thorough and analytical search" to find a provider; it must consider whether to hire an expert to help assess the market; and it must have "appropriately concluded that the annuity provider would be financially able to make all future payments under the contract and [determine that] the cost of the contract is reasonable."

The Labor Department is expected to finalize the rule within the next few weeks.

The agency is likely hearing that practitioners are grateful that protection is being put in place, although they are wary about its complexity.

"It’s not an easy process, but at least it’s a followable process," says Jon Chambers, a principal at investment consulting firm Schultz Collins Lawson Chambers in San Francisco.

But just because employers will soon have protection against being dragged into court on charges that they didn’t select the "safest" annuity available doesn’t mean that they’ll now embrace annuities as a distribution option.

David Wray, president of the Profit Sharing/401(k) Council of America, says the problem is that too few of the 52 million people who have defined-contribution accounts want to put their retirement savings into annuities.

"As long as the demand for an annuity distribution payout is low, plan sponsors are not going to expend the time and resources necessary to follow the [safe harbor] process," Wray says. "This area is not going to command much plan-sponsor attention until the marketplace comes up with solutions that participants desire. It’s a demand-based issue."

Currently, the vast majority of workers roll their 401(k) plan into an individual retirement account when they retire, according to Wray. Or, they leave their money in their 401(k) and take it out in installments. They have shied away from annuities because the products have developed a bad reputation for being expensive, complex, inflexible and too conservative.

A couple of years ago, "annuity" was almost a dirty word. But now, Chambers says, improving annuity products and changing retirement circumstances are casting them in a different light. More people say they are worth considering.

One reason is Americans’ increasing anxiety about retirement security. The issue that gets the most attention is the level of savings. Even though there is a total of $7.5 trillion in 401(k) and other defined-contribution plans, many individuals have far too little money saved to finance a comfortable retirement.

Another equally scary dimension of retirement stems from what is essentially good news for humankind. Scientific advances keep adding years to the average person’s life expectancy. The drawback is that the longer someone lives, the more retirement savings they consume.

Assuaging that fear through guaranteed income has become one of the selling points for annuities as the payout mechanism for 401(k) plans.

"Annuities shift the longevity risk from the individual to institutions," Chambers says.

Such an adjustment benefits participants, according to Chambers. "We want to make our plans better," he says. "We want to give people choices they didn’t have in the past."

A 2005 study by the MetLife Mature Market Institute and Mathew Greenwald & Associates seems to confirm that annuities can reassure retirees about the phase of life that they’re entering.

Retirees with income from a pension and annuity were three times as likely to say that "retirement is much better than expected," according to the report, "The Silent Generation Speaks."

A Hewitt Associates survey in 2003 found that 69 percent of workers and 86 percent of retirees rated guaranteed lifetime income as "very important."

Jody Strakosch, national director at MetLife, says that guaranteed income "provides great comfort and security to participants. The peace of mind is huge."

The fact that their employees may now have these attitudes could spur companies to adopt annuity payout distribution. About one-third use it now.

"Many of them are thinking about it, but it’s hard to predict how they will act," Strakosch says.

But she says that the logic behind using an annuity is compelling, especially because of concerns about people taking a lump-sum payment at retirement, spending it too quickly and ending their lives in poverty.

"The longer you live, the more money you need to have," Strakosch says. "That resonates [with plan sponsors]. They understand that."

Fredrick Conley, president of the institutional retirement income group at Genworth Financial, says that companies that encourage workers to save for years are reluctant to shove them off into retirement without guidance.

An annuity can provide a road map for spending. "They want to give employees a path," Conley says of employers.

But a participant is usually reluctant to jump into an annuity once he or she retires.

"Retirees are pretty averse to a really large immediate annuity purchase," says Jason Scott, managing director of the Retiree Research Center at Financial Engines.

How much money they should sink into an annuity depends on their individual circumstances, experts say. Some participants may want an income of $800 each month. Others may need $2,000.

In addition, some may want an immediate income annuity, which starts paying out at age 65. Others may opt for a deferred-income product, which is known as longevity insurance. It would start paying out in later in life, perhaps when the participant reaches his or her mid-80s.

One of the drawbacks of longevity annuities is that they are hard to find, Scott says.

But insurers and financial companies are beginning to offer annuities with more flexibility and more protections, Wray says.

"There are innovative annuity solutions being developed that respond to the interests of consumers," he says. "The people who provide annuities are responding to the marketplace."